Euro stabilisation plans are flawed

The EU, national governments, academics and media are discussing how to rebuild the shattered EMU stability framework, after the Stability and Growth Pact failed to prevent the current crisis. In particular, its weak enforcement mechanism is said to be responsible for the failure.

One proposal for a new stability framework by the European Commission demands more centralisation of fiscal policy. National budget plans would be submitted to and approved by the EU in advance of national legislation. However, this would undermine national sovereignty and would be a further step towards political union.

An alternative framework would see the adoption of very tight fiscal rules (which will become law in Germany from 2011 onwards) for the whole EU. This so called “debt brake” allows structural net borrowing of just 0.35% of GDP. However, the failure of the Maastricht criteria suggests that such rules could be undermined by political pressure. There is also a problem with enforcement.

One recommendation to improve enforcement is to cut EU money for countries that do not stick to the rules. This proposal seems plausible, but it will fail if it is applied to a net paying country. Such a country might offset the cuts with lower contributions to the EU. Further proposals, such as excluding countries from voting in EU legislation or the threat to expel a country from the euro, also have significant drawbacks. Both options conflict with the “European Idea” and might promote nationalism and resistance against the EU, making a break up of the eurozone even more likely.  

A better way to avoid a repeat of the current crisis may be to rely on market mechanisms. This implies that a eurozone country can default, either with no restrictions or regulated by an insolvency procedure. However, for market-based restraints on government profligacy to be effective, the EU must make a clear and credible commitment to a no-bailout rule. Regaining credibility may prove difficult in the context of the current multi-billion-euro bailout package.

 

See also Philip Booth’s article,  ”Europe should have allowed Greece to default“, in City AM.

Naturally it is hard to prop up artificial political constructs which tend to come apart under pressure. If countries in the eurozone cannot devalue their currency, there are three ways for their economies to adjust: (1) reduce some real wage-rates; (2) force workers to emigrate; (3) subsidise some regions at the expense of others. Many years ago Sir Donald MacDougall pointed out that without at least one of these three methods, the eurozone would simply become a low growth, high unemployment club. Making up rules which either France or Germany or both (not to mention other countries) are not going to take much notice of is hardly an answer.

It is instructive to examine how economic adjustments take place in other currency unions such as the United States. Labour mobility appears to play a key role. Detroit, for example, has lost something like two-thirds of its population since 1960. By contrast, other cities, such as Las Vegas and Houston, have seen big population increases. It is difficult to see this mechanism operating on such a scale in the eurozone, given language and cultural barriers, not to mention strict planning controls and labour-market regulations.

Agreed; and given the ECB’s antipathy to currency debasement (understandable in view of the history of German money in the twentieth century), it is not to be expected that inflation will be much ‘help’ in allowing real wage-rates to adjust. That only leaves regional subsidies, which, as everyone foresaw, are hardly feasible on a large or continuous basis without political union. That is why the Germans (and others) said you should have political union before monetary and economic union.The question now seems to be: will there be further progress towards political union or will the eurozone break up?

One way for Greece to default (if that’s the right word) is to engineer the collapse of one or more private institutions which hold its debt. The institution’s assets would be sold off on firesale. The Greek government could then step in to buy back its own debt certificates at a fraction of the price it sold them for.Alternatively, and not quite so elegantly, the Greek Parliament could by legislation exercise the power of eminent domain over its creditors.

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